Tuesday, 29 November 2011

Markets update - Credit - The Eye of the Storm.

"The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore."
Vincent Van Gogh

As we move towards the nth European summit of the last chance on the 9th of December and with liquidity becoming scarce by the day, in today's post we will review ongoing liquidity issues, as well as some recent market developments and some previous calls.

On the recent price action, my good credit friend commented:
"As equity traders still enjoy a kind of Bull Run based on very thin air, credit traders keep on focusing on facts that could alter the metrics for the months to come, or, on events that could change the credit momentum. Even though European politicians have finally understood what needs to be done to place their economies on a strong footing, they are facing many hurdles, as political agendas collide with the needed structural reforms. So, it will take a lot of time, and time is a luxury that market participants cannot afford. Why? Because the overall system and our society does value “time” as something that humanity as a whole is short of. Consequently, we are experiencing a major social shift in term of savings behaviour and capital allocation. This is what I call a global re-pricing of all assets, which bears a lot of risks if it occurs disorderly."

But first, as always, it is time for a credit market overview before our long conversation.

The worsening liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

The current European bond picture with contagion to core Europe - source Bloomberg:

German 10 year government yield rising in lockstep with German 5 year sovereign CDS, following the failed auction casting doubt on the safe haven status of German bonds which had prevailed so far this year - source Bloomberg:

The Credit Indices Itraxx overview - Source Bloomberg:
While we have somewhat receded since our last post, in relation to CDS credit indices levels, volatility remains elevated, and liquidity is becoming an issue, given bid-offer spread for Itraxx Financial Subordinate 5 year CDS is 10 bps whereas it is is only 5 bps on the Itraxx Crossover 5 year CDS index (European High Yield gauge).
A market maker commented:

"Another fairly thin session as we approach Dec 9. Environment continues to be tough to trade -- just take a look at some of the intraday index moves. It becomes increasingly more difficult if you're a single name bank cds trader and trying to "hedge" your book. You are guaranteed to lose money on almost every occasion as you cross bid/offer."
Intraday movement remains indeed very elevated in the Credit Indices space:
Itraxx Financial Senior 5 year index closed around 340 bps (today's range was 330-355).
Itraxx Financial Subordinate 5 year index closed around 588 bps (today's range 569-626...).

Itraxx Financial Senior 5 year CDS versus Itraxx Subordinate 5 year CDS - source Bloomberg:

The same market maker commented on the above:

"Snr vs Sub relationship in Index is also not moving. You would have expected the spread to decompress in the widening but it did not even blink. The only real explanation for this, is because nobody feels like buying Sub protection at these levels; which is fair if you don't think LT2 will get haircut and believe CDS will go to zero one day (post Basel III)."

In relation to LT2, as a reminder from our September credit conversation "Credit - Crash Test for Dummies":

"Typically, in subordinated CDS single names, the bond reference is a Lower Tier 2 bond (LT2), and not Tier 1 (T1) bonds or Upper Tier 2 bonds (UT2), as coupon payments can be deferred in these structures. For Tier 1 bonds and UT2, missing a coupon does not constitute a credit event, therefore they cannot be used as a reference for a single name financial subordinate CDS, so no CDS on these bonds."
In our September post we discussed:
"If a financial entity is able to buy back its LT2 debt below par, it generates earnings and then Core Tier 1 capital. It's a kind of magic...because this way a bank's total capital base goes down (by retiring LT2 debt) and given regulators care most about the Core Tier 1 ratio, everyone is happy (probably note the subordinate bondholder)."
We would have to disagree with the market maker in the sense that we could go wider still on the Itraxx Subordinate 5 year CDS index, given the market doesn't fathom the possibility of getting haircuts on LT2 subordinate bonds. It has happened and will happen again for weaker financial institutions in the peripheral countries.

Tracy Alloway in FT Alphaville on the 22nd of October described what happened in Ireland, for Anglo Irish Bank subordinate bondholders in her post - "Anglo Irish’s burden-sharing template":

"The bank is offering holders of some of its outstanding sub-debt to swap their notes for new Irish government guaranteed bonds that will be due in 2011 with a coupon of three-month Euribor plus 3.75 per cent. Holders of the €1.57bn worth of three Lower Tier 2 (LT2) bonds will receive just 20 cents on the euro. Investors in about €377m of perpetual junior debt will get even less — 5 cents on the euro."
And Tracy also reminded us what happened in 2009 in the UK in relation to the Bradford and Bingley precedent:

"In 2009, the nationalised British bank enforced burden-sharing on both LT2 debt and perpetuals — offering 45 pence for every pound of LT2, and 25 pence on perpetuals. That was a premium of about 10 to 12 points at the time.

Bradford and Bingley burden-sharing, however, also came with a ‘special resolution regime.’ The UK government went ahead and changed the terms of outstanding Bradford & Bingley subordinated bondsallowing the bank to defer coupon and principal payments."

And Tracy concluded at the time:
"The future is here, and it bites for bondholders."

We already know the score given the flurry of bond tenders which we had seen coming fast and furious following Spanish bank Santander's bond tender. Given the wall of refinancing for banks in 2012 we detailed previously, we would therefore disagree with the current credit market assumption that LT2 haircut will not happen again and Itraxx Financial Subordinate CDS index could go wider still. This time is different? Probably not, given the European Banking Association's willingness to ensure European banks reach 9% Core Tier 1 capital ratio by 2012.

"Something has gotta give" - subordinated bondholders or shareholders, or both, we argued recently.

It seems Moody's Investors Services is confirming our September assumption given it is considering lowering debt ratings for banks in 15 European nations to reflect the potential removal of government support. This will likely help banks quietly retire their LT2 bonds at even more discounted levels, shoring up in the process somewhat their Core Tier 1 capital. According to Jacob Greber and Chitra Somayaji in their Bloomberg article - Moody’s Considers Bank Debt Downgrade in 15 European Nations published on the 29th of November:
"All subordinated, junior-subordinated and Tier 3 debt ratings of 87 banks in countries where the subordinated debt incorporates an assumption of government support were placed on review for downgrade, the ratings company said in a statement today. The subordinated debt may be cut on average by two levels, with the rest lowered by one grade, it said.
Lenders in Spain, Italy, Austria and France have the most ratings to be reviewed as governments in Europe face limited financial flexibility and consider reducing support to creditors, the rating company said. Moody’s has said that a “rapid escalation” of Europe’s sovereign debt crisis threatens the entire region."

The difficulties for banks to issue term funding debt have been a recurring theme in our conversations. The two journalists from Bloomberg also added:

"Banks will cut bond sales by 60 percent in Europe next year as the sovereign debt crisis drives up issuance costs, Societe Generale predicts. Lenders will sell 50 billion euros ($67 billion) of senior notes, down from a euro-era low of 121 billion euros so far this year, according to the French bank.
The extra yield that investors demand to hold European bank bonds is the highest since May 5, 2009, widening to 424 basis points on Nov. 25 from 336 on Oct. 31, Bank of America Merrill Lynch’s EUR Corporates Banking index shows."

In the great European bank deleveraging process, not even German bank Commerzbank is immune according to Bloomberg journalists Nicholas Comfort and Aaron Kirchfeld - Debt Crisis Puts Commerzbank Back to Drawing Board Fighting Aid:

"Commerzbank AG Chief Executive Officer Martin Blessing spent the last three years trying to free Germany’s second-largest lender from the shackles of government aid needed to survive the 2008 credit crunch. Europe’s debt crisis may put him right back where he started.
Blessing, 48, this year pulled off a capital increase of 11 billion euro($14.6 billion), among the biggest ever in Germany.
The stock sale, a conversion of shares held by the government and excess capital enabled the Frankfurt-based lender to repay 14.3 billion euros of government aid in June. Blessing has pledged not to accept state funds again, even as Commerzbank comes under pressure to boost capital to meet tougher requirements.
European leaders are demanding banks bolster their capacity to withstand losses after financial firms agreed to accept losses on Greek sovereign debt. Commerzbank, told by the European Banking Authority last month that it may need 2.94 billion euros in fresh capital, may have to raise as much as 5 billion euros in a worst-case scenario, people familiar with the situation said last week. “If the bank’s capital requirements rise significantly, it would be very hard for Commerzbank to reach them with the traditional measures they have to hand,” said Michael Seufert, an analyst with Norddeutsche Landesbank Girozentrale in Hanover. “Taking state aid again would be the very last option they’d try as it would be seen as a signal of weakness.”

So subordinate bondholders beware as the article added:
"Commerzbank is exploring options including buying back hybrid bonds and placing sovereign holdings in an external entity, or bad bank, one of the people said. The goal remains to avoid taking state aid. The bank already announced plans to scale back risk-weighted assets and new loans, and to sell non-strategic businesses.
The bank may have to seek assistance from Germany’s Soffin bank-rescue fund, which the government plans to reactivate, if the EBA significantly raises its capital requirements, one person said last week.
Commerzbank’s consideration of putting sovereign debt into a bad bank was reported by the Financial Times on Nov. 25, while the Financial Times Deutschland said yesterday the bank is weighing buying back as much as 1 billion euros of hybrid bonds in exchange for new shares."

In our conversation "Goodwill Hunting Redux", we were expecting this eventuality of debt to equity to materialise:
"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process."

As for mortgage insurer PMI we mentioned in our post "Credit Terminal Velocity", in August, where we discussed the future for the mortgage insurance business, it is indeed goodbye PMI.
By Mary Childs and Sapna Maheshwari, November 29 (Bloomberg):
"Bondholders are unlikely to recover as much as PMI Group Inc., the guarantor of U.S. home loans that filed for bankruptcy protection last week, indicated in its Chapter 11 petition, debt-market trading shows.
PMI, which pays lenders when homeowners default and foreclosures fail to recoup all of the mortgage debt, reported $225 million of assets and $736 million of debt as of Aug. 4 in its Nov. 23 filing. That means senior bondholders would get about 30 cents on the dollar. Credit-default swaps on Walnut Creek, California-based PMI signal a recovery expectation of 20 cents on the dollar for its senior bonds, according to data provider CMA. The company’s $250 million of 6 percent senior unsecured notes due in September 2016 traded at 22.75 cents on the dollar on Nov. 23
The insurer’s assets may have deteriorated since August, according to analysts at debt researcher CreditSights Inc. They said in a Nov. 27 note that the assets in the filing were higher than they are now and the company likely would be liquidated."

The Bloomberg team interviewed a fixed-income strategist on the subject:
"“The fundamental question behind whether a company can restructure or must liquidate in bankruptcy is whether that company has a viable business model,” Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia, said in an e-mail. “Whether PMI is able to restructure or ends up in liquidation is essentially a referendum on the mortgage insurance industry as a whole.” Mortgage insurance may not be a sustainable business because home prices have proven to move in sync, making it difficult for providers to diversify, he said.
If mortgage insurance pricing rebounds, PMI’s liquidation would reduce competition and allow for better conditions for those who remain such as Radian Group Inc. and Genworth Financial Inc., LeBas said."

Survival of the fittest...PMI 5 year CDS in upfront price, indicating the recovery for Senior bonds will be in the region of 26 cents to the dollar, definitely less than the assumed 40% recovery rate in the senior CDS - source Bloomberg:

On a final note I leave you with Bloomberg Chart of the day, showing that "Investors are shifting haven demand out of core Europe and in to foreign markets as the region’s debt crisis reaches its most fiscally sound nations, according to UBS AG."

"The CHART OF THE DAY shows the 120-day correlation coefficient between French and German 10-year yields and the euro-dollar has fallen from highs earlier this month. The correlation between U.S. Treasuries and the currency pair continues to increase as the common currency is sold to buy debt outside the euro zone. The measure for 10-year U.K. gilts also remains stronger than Germany and France."

"The only safe ship in a storm is leadership."
Faye Wattleton

Stay tuned!

Wednesday, 23 November 2011

Markets update - Credit - The song of Roland

"In The Song of Roland, Roland carries his olifant (ivory hunting horns made from elephant tusks) while serving on the rearguard of Charlemagne's army. When they are attacked at the Battle of Roncevaux, Oliver tells Roland to use it to call for aid, but he refuses. Roland finally relents, but the battle is already lost. He tries to destroy the olifant along with his sword Durendal, lest they fall into enemy hands. In the end, Roland blows the horn, but the force required bursts his temple, resulting in death." - Source Wikipedia.

The recent developments in our ongoing European tragedy inspired me this time around to use this particular legendary reference namely "The song of Roland". It is an interesting analogy as Oliver (European leaders) are asking Roland (Germany) to use the Olifant (to unleash the unlimited resources of the ECB) to call for aid (ECB). In the end, Roland blows the horn...but is it already too late for Europe?

But yet again, I divagate in my thoughts. Time for a Credit Market overview as there are many items to discuss, some of our calls, as well as one of an earlier subject we previously discussed, namely the consequences of the disappearance of risk-free rates in Europe.

The Credit Indices Itraxx overview - Source Bloomberg:
New records across the board in an environment where: liquidity is dwindling and volatility higher still.
A market maker commented:
"Nobody wants to be short risk coming into year end and the European Council meeting. This market is really tough to trade."
Itraxx Financial Senior 5 year CDS index breaking a new record closing around 342 bps (Intraday range 304-339 bps), Itraxx Financial Subordinate 5 year CDS index getting close to 600 bps mark around 591 bps (intraday range 540 - 588 bps).
The same market maker added:
"SovX, Fins Snr and Fins Sub have now reached a new all time record as London is closing. And main (Itraxx Europe 5 year CDS index - investment grade gauge) is only a couple of basis points away from its March 2009 record of 214 bps. Will it be enough for Germany to change its mind and allow the ECB to come to the rescue? I don't think so as despite the move there is no real pain out there from clients or dealers. We need French OAT to sell off more or get a large European Bank to run out of assets to pledge to the ECB. We are going to put more hope on the Dec 9th meeting and at these levels of stress and where indices are trading I would not want to be short anymore. I am missing the capitulation leg to go long risk but we are not too far away from that level. "
Will we hear Roland's olifant?

As my good credit friend put it about today's moves:
"Very large widening of credit indices! Sub Financial is at the widest ever and there is no reason to expect any significant pull back as the global picture is terrible. The momentum is gaining steam and speed, and I suspect we will have a panic and a capitulation very soon. A Global Re-Pricing of all assets is on its way, so we could gap hard anytime. Fasten your seat belt!"
Here is an update from our previous post "Mind the Gap", finally the disconnect we mentioned on the 15th of November between the German Bund and the Eurostoxx has ended and the gap closed - source Bloomberg:

But interestingly there was no flight to quality this time around, given the very poor auction of the German debt agency today. Newedge Chicago had to say the following on the results:
"The German debt agency sold EUR 3.644bn of its new 10y Bund 2% Jan 2022 this morning. The Buba retained a massive EUR 2.356bn. Demand was very poor at EUR 3.889bn for a modest 1.1 bid/cover. Without the massive Buba's retention the auction would have been heavily undersubscribed."
It seems there is a buyer strike going on in Europe, courtesy of the disappearance of the failed notion of risk-free, which is at the foundation of the "Modern Portfolio Theory". We previously discussed this phenomena back in September in our post - "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!"

We argued at the time:
"Safe havens no longer exist. The game was based on confidence, on risk-free interest rates and fiat-money based on the trust we had in our governments."
and added:
"Confidence is the name of the game and the perception of the risk-free interest rates, namely a solvency issue is at the heart of the ongoing issues."
One of the indicator we have been following in our various credit conversations has been the spread between 10 year Swedish government yields and German 10 year government yields. It looks like this relationship is broken - source Bloomberg:
From March onwards German Bund yields had been moving in lockstep with 10 year Swedish government yields. The spread broke the 25 bps high level reached in August and widened significantly to close at 52 bps. A very significant move.

My good credit friend and I discussed the following points:
"Now that the concept of “risk free assets” is being removed from what some people call “modern finance”, there is a slow understanding that every investment bears a “credit risk”. So now comes “re-pricing time”! To be true to ourselves, there has never been such a thing as “risk free” investments, and there has never been such a thing as “modern finance” but only “modern products”, sophisticated ones created by mathematicians. Once more, the “modern finance” concept is just a “wording” to cover up human beings' fears and greed. How good and reassuring it is to invest without risk and make nice profits! But such a thing cannot last, as it does not really exist."
So, dear friends, welcome to a credit world! Where defaults can happen and repayment of principal cannot be taken for granted.

This is the current European bond picture with contagion now spreading to core Europe, not even the Netherlands or Finland were spared - source Bloomberg:

And our CPDO/EFSF is now closing towards the 4% yield - source Bloomberg:

The disturbing liquidity picture in four charts. ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

In his credit letter published in August, Dr Jochen Felsenheimer from Assénagon made the following valid points:
"Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing. Particularly those in currency unions with explicit - or at least implicit guarantees. It is just such structures that let government increase their debt at the cost of the community. For example, in order to finance very moderate tax rates for their citizens so as to increase the chance of their own re-election (see Italy). Or to finance low rates of tax for companies and at the same time boost their domestic banking system (see Ireland). Or to raise social security benefits and support infrastructure projects which are intended to benefit the domestic economy (see Greece). Or to boost the property market (Spain and the USA). This results in some people postulating a direct relationship between failure of the market and failure of democracy."
As we previously discussed in our September post about "The curious case of the disappearance of the risk-free interest rate and impact on Modern Portfolio Theory and more!" and relating to our assertion of moving to a credit world:
"The lower the confidence, the higher the rates issuers will have to pay to raise capital. Solvency of the issuer will ultimately determine the allocation of the capital."
To further illustrate the above, Credit Suisse published on the 23rd of November the following note entitled "Earthquake warning" and had to say the following:
"A more lasting source of despair is the lack of understanding of the issues in most key circles. It seems axiomatic that before a serious problem can be tackled, its nature has to be understood. If there’s a hole below the waterline in your boat and the water has caused engine failure, then tackling the leak becomes rather important as opposed to cursing the malign intent of the water while changing the plugs. Mapped to Europe, WHY are bond markets closing?
Of course; “evil New York hedge funds” and their CDS. How foolish of us to forget. That’s good, because we can ignore the correlation crisis.
Vetoes of the ECB as a lender of last resort are a case in point. It cannot be the lender of last resort because it is the lender of first resort, to the tune of €550 bio and counting (fast).
We risk excessive repetition but the accounting identity between a euro member state’s BoP deficit and the NCB’s balance at the ECB ensures that. So, to [editorialize] a recent comment from BuBa President Wiedemann, speaking on Italy and Spain: "In both cases, I am confident that these countries need no outside help but rather that they can comfortably help themselves [to limitless BoP funding at the ECB], and that the new governments will take the necessary measures [to ensure that they can continue to do so]". i.e., stay in the euro.
The Greek government had rumbled that ruse, as apparently had Sr Berlusconi; so both governments had to go, stat. But this particularly extreme form of the par pretence is on borrowed time. There is currently no exogenous constraint on the current account financing of any euro area member state. And if we accept that the present level of current account deficits is unsustainable, which has certainly been the view of private sector participants, then under “Stein’s law” ("If something cannot go on forever, it will stop") the only question is how it stops, and to a degree when.
This is the (currently binding) hole in the SS Euro."
In relation to EFSF Credit Suisse had to say the following:
"And, as with all the challenges in the euro area—anywhere--the key to managing a risk is to understand that it exists, for both buyer and seller. Relative to our analysis of the tranche structure of the euro area, we regard the observation that the EFSF has a tranche structure as being simple. Senior tranche, bond-holders; junior tranche, guarantor governments. As correlation rises, expected losses are transferred relatively to the senior tranches. So EFSF bonds will underperform in an environment where the risks systematize and outperform as they become more idiosyncratic. And the missed opportunity to restructure Greece in 2010 meant that an idiosyncratic crisis could not be tolerated—we always rejected the concept of a “Greek crisis”—so the underperformance of the EFSF is entirely accounted for conceptually, as well as more anecdotally in terms of France’s AAA rating and the like, which are manifestations of the same phenomenon."
Credit Suisse also made an important point in their recent note:
"European credit is wholly reliant on German credit. And of course, via the banking system and credit markets, German debt is very largely reliant on European. If we are heading, as we appear to be, where all non-German issuance is closed (and German not certain, for reasons we examine later, and as we saw on 23 November), then the whole structure turns on how much of the debt can be mutualized."
On a final note I leave you with Bloomberg Chart of the Day, showing the market positioning for a collapse of the euro:

"The CHART OF THE DAY shows options traders turned the most bearish ever on the euro on Nov. 16 and the currency fell to its least in more than a month against the dollar the following day. The euro, which traded at $1.3518 as of 7:16 a.m. in London on the 21st of November, probably will drop 4 percent to $1.30 by year-end, according the Nomura, Japan’s biggest brokerage. The lower panel shows wagers by hedge funds and large speculators on a euro decline, compared with bets on a gain, increased last week for the first time in a month after Italy’s 10-year bond yield rose to a euro-era record over Germany’s earlier this month."
"All enterprises that are entered into with indiscreet zeal may be pursued with great vigor at first, but are sure to collapse in the end."

Stay tuned!

Sunday, 20 November 2011

Markets update - Credit - Goodwill Hunting Redux

"Errors of opinion may be tolerated where reason is left free to combat it."
Thomas Jefferson

Dwindling liquidity has been leading to significant market volatility, in most asset classes. Credit hasn't been spared and while CDS single names and indices are still experiencing important intraday spread movements, Cash bonds in the European markets are not spared either. Thursday and Friday were very interesting, namely because we saw an important acceleration of bond tenders in the financial space (triggered by the Santander bond tender we mentioned in our "Mind the Gap" on the 15th), something we have been expecting to happen from our many previous conversations("Subordinated debt - Love me tender", "Crash Test for Dummies"). In fact in a more recent conversation ("Complacency") we argued:
"Something has gotta give" - subordinated bondholders or shareholders, or both.
Well, it looks like subordinated bondholders are the first in line, and are going to give some back, to help European banks shore up their Core Tier 1 capital as they rebuild/shrink their balance sheet in order to meet the June 2012 European Banking Association threshold of a core Tier 1 of 9%.

In today's long credit conversation, as we go through the latest price action and bond tenders, we will revisit Goodwill impairment, which is definitely back on the agenda, a subject which we already approached in December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet").

But first it is time for a market overview:

The Credit Indices Itraxx overview - Source Bloomberg:
So, three weeks after a supposedly historic agreement on the 26th of October,  we are still near records levels CDS indices wise (Financial indices, and SOVx - European CDS sovereign risk gauge). Itraxx Crossover 5 year CDS index (High Yield gauge) is at around 760 bps, while Investment Grade Europe represented by Itraxx Europe Main 5 year CDS index is around 188 bps.

Itraxx credit indices for Financial Senior 5 year CDS and Financial Subordinate 5 year CDS, remain stubbornly high (300 bps and 538 bps respectively, close to September records level) - source Bloomberg:

Some respite in the Sovereign European CDS Space - source CMA:
[Graph Name]

In relation to the bond picture, contagion has been spreading to core Europe last week with some respite as well for France and Austria, as well as a pause in the flight to quality with German 10 year yield increasing, but for how long?- source Bloomberg:

In relation to our CPDO/EFSF relationship with French 10 year Government bond and German 10 year bund yields, while French OAT yields have receded, EFSF bonds yields are still rising towards 4%, currently at 3.87% - source Bloomberg:

Another indicator worth tracking is the relationship between 10 year Swedish Government yields and German 10 year Government yields, which, so far have been moving in lockstep, but recently spread between both are moving towards their highest level of 25 bps (contagion to Germany? Not yet) - source Bloomberg:

As far as the liquidity picture is concern, it is clearly deteriorating. The new reserve period for deposits at the ECB which started on the 9th of November will last this time around 35 days:

In relation to the liquidity update, please find an additional point made by Goldman Sachs Sales/Trading teams on EUR FRA/OIS Basis:
"FRA/OIS Basis shows the difference between the overnight and the 3 month interbank borrowing rate and shows the confidence of banks to lend to each other. Current levels show that the confidence is very low as the premium to borrow long term is very high despite recent unlimited LTRO (long term refinancing operation) by the ECB."
In our last conversation on the 15th, we discussed the latest bond tender by Santander in Europe, which in fact triggered a flurry of bond tenders in the market according to Bloomberg article by Esteban Duarte on the 18th of November:
"Societe Generale SA and Banco Santander SA are among banks offering to buy back or exchange part of about $30 billion of junior debt issuance to boost capital and raise money as borrowing costs rise.
The bond tenders that started in Europe this week allow the banks to repurchase subordinated notes at a discount, booking a capital gain, or swap the securities to raise senior debt. Others pursuing the strategy include BNP Paribas SA, France’s biggest bank, and Northern Rock Asset Management Plc, the so- called bad bank spun off from the lender being purchased by Richard Branson’s Virgin Money Holdings U.K."
And the article to detail the flurry of bonds tenders we have been expecting for a while:
"SocGen offered to repurchase as much as 900 million euros of a total $8.2 billion of Tier 1 notes today, at prices starting at 56 percent of face value. Banco Santander, the biggest Spanish lender, asked holders of 6.8 billion euros of subordinated bonds to swap their securities for new senior notes on Nov. 15.
BNP Paribas, France’s largest bank, offered to exchange or repurchase part of about $10 billion of subordinated bond issuance yesterday for as little as 72.5 cents on the dollar, according to a series of statements. SNS Bank BV of the Netherlands announced a tender of Lower Tier 2 notes yesterday, while nationalized U.K. bank Bradford and Bingley Plc is also tendering for debt."
Love me tender?

We already know the liquidity is poor and we discussed previously how issuance under current market conditions is difficult to say the least, it isn't really a surprise to read in the same article:
"“Banks are currently taking advantage of poor liquidity in the market to buy back, or more often exchange, redundant capital instruments on very attractive terms for the issuer,” said Mark Harmer, an analyst at ING Groep NV in Amsterdam.
It’s definitely a growing trend, especially where traditional access to senior funding channels is limited.”
Given we already know 2012 is going to be a significant year for term issuance for banks ("Mind the Gap..."), you can expect more of the same. First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process.

It was interesting to see as well Deustche Bank increasing the size of a previous 2 year Senior Unsecured FRN (Floating Rate Note) issue by 250 million euros (previous issue size was 1.75 billion Euros, maturity October 2013), at 3month Euribor +75bps.

So yes there is worrying liquidity and funding stress in the European financial system, and according to Bloomberg Liz Capo and Gavin Finch in their article - "Bank Stress Gauges Show Pain Lasting Through ’11: Credit Markets":
"Spanish banks borrowings from the ECB rose 10 percent to 76 billion euros in October, the highest level in more than a year, while Italian firms reliance increased 6 percent to 111.3 billion euros."
And added:
"Italian banks may be forced to increase their reliance on emergency funding from the ECB as their liquidity levels have fallen to levels not seen since January 2009 after the value of the government securities they held tumbled, the central bank wrote in its Financial Stability Report published on Nov. 3.
The ECB announced in October it would reintroduce year-long loans for the regions’ banks as the sovereign debt crisis threatens to lock local money markets. It had previously coordinated with the Federal Reserve to provide euro-area banks with dollars. The central bank offered 12-month loans last month and will off a 13-month loan in December."
According to Radi Khasawneh in the article published on the 18th of November - Italian Banks May Need $8.2 Billion as Government Bonds Slump:
"Italy’s five biggest banks, including Intesa Sanpaolo SpA, may need to raise a combined 6.1 billion euros ($8.2 billion) of additional capital as the Italian government bonds they own deteriorate in value.
Two-year Italian debt, which the banks valued at 97 cents on the euro or better on Sept. 30, trades at about 92.7 cents.
That suggests Intesa, UniCredit SpA, Unione di Banche Italiani
SCPA, Banco Popolare and Monte Dei Paschi di Siena SpA need more capital, today’s Bloomberg Risk newsletter reports."
Given the issue of circularity discussed in our previous post, the more pressure we get on Italian sovereign spreads, the more capital, they will need to raise.

All of the above lead us to revisit a subject we approached already in December 2010 as indicated above, and my good credit friend to comment:
"In term of credit market, following Santander, SNS bank and BNP…Here comes SocGen announcing a tender offer on $1.2 billion of subordinated debt! Hooray! The haircut is 44 %, the tender price is 56%…. I guess the bank will do better next time, if there is a “next time” and will offer tender prices below 50 %.

Tip for “banks’ friends”: First came dividends cuts, then bonds haircuts. Next, we will see some massive write-off (Goodwill ?). UniCredit started, others will follow. The path will be very painful for both shareholders and bondholders."
"Goodwill is an accounting convention that represents the amount paid for an acquisition over and above its book value. Under the accounting rules European banks use, the International Financial Reporting Standards, companies have to write down goodwill on their balance sheets if the underlying assets have permanently deteriorated in value."

Indeed, it will be painful. According to Liam Vaughan and Charles Penty, "EU Banks Face $270 Billion Goodwill Hangover for Past Purchases":
"European banks may have to write down some of the $270 billion of goodwill from their purchases in the run up to the financial crisis before they can sell assets, or new stock, to bolster capital.
UniCredit SpA, Italy’s biggest lender, this week opted to take an 8.7 billion-euro ($10 billion) impairment charge following a series of acquisitions at home and in eastern Europe. Other European banks are yet to follow, analysts said.
Credit Agricole SA, Banco Santander SA and Intesa Sanpaolo SA are among European banks with the most goodwill remaining on their balance sheets, according to data compiled by Bloomberg.
Banks that paid a premium for businesses when the outlook was better will need to reassess the goodwill on their balance sheets,” said Andrew Spooner, an accounting partner at Deloitte LLP in London. “Previous acquisitions which are exposed to peripheral Europe are most vulnerable to impairments.”
We already discussed Austria's exposure to Eastern Europe ("Long hope - Short faith"). Erste Bank in fact, wrote down the value of its Hungarian and Romanian units by a combined 939 million euros in October.

Liam Vaughan and Charles Penty also commented in their article:
"UniCredit wrote down goodwill on assets in its home market, eastern Europe and former Soviet Union countries in its third-quarter earnings report this week, though it didn’t tie the charge to any specific deals among the $60 billion of acquisitions it made from 2005 to 2008."
In December 2010 ("Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet"), this is what we discussed as a reminder:
"When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.
As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital."

On June 29, 2001, The Financial Accounting Standards Board (FASB) unanimously voted in favor of Statement 142, Goodwill and Other Intangible Assets. Prior to this statement, goodwill was amortized over its useful life not to exceed forty years. Under FASB 142, goodwill will still be recognized as an asset, however, amortization of goodwill will no longer be permitted. Instead, goodwill and other intangibles will be subjected to an annual test for impairment of value. This will not only affect goodwill arising from acquisitions completed after the effective date, but will also affect any unamortized balance of goodwill."
We also indicated at the time:
"Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks.

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks."
And we concluded back then:
"Large Goodwill Impairments increase the debt to equity ratio.
It is therefore paramount to track goodwill impairments in relation to future banks earnings."
For more on the subject, Bloomberg Columnist Jonathan Weil had an interesting column relating to Goodwill impairments - "UniCredit Bombshell Shouldn’t Be the Last One".

Time has come once again to become "Goodwill hunters" in relation to bank earnings!

On a final note I leave you with Bloomberg Chart of the Day from the 18th of November relating to debt collection in Spain (the hunt for bad loans...):
"The CHART OF THE DAY shows the proportion of staff in Bankia SA, Banco Popular Espanol SA and the Spanish unit of Banco Bilbao Vizcaya Argentaria SA working in the banks’ collections teams. The second panel shows the amount of bad loans being chased by each of the collection units’ employees. “I’d say it’s more crucial than ever for the Spanish banks to show they’re trying as hard as they can to recover bad loans,” John Raymond, a southern European banking analyst at CreditSights Inc. in London, said in a phone interview.
As the country’s property crash and a stalling economy drive up defaults, the bad-loans ratio of Spanish banks rose to 7.16 percent in September, the highest level since November 1994, according to Bank of Spain data."

"I believe that banking institutions are more dangerous to our liberties than standing armies."
Thomas Jefferson

Stay tuned!

Tuesday, 15 November 2011

Markets update - Credit - Mind the Gap...

"There is a time to take counsel of your fears, and there is a time to never listen to any fear."
George S. Patton

Following our previous post relating to the "Italian Peregrine Soliton", it was interesting to read about Grant Williams comparable analogy relating to the freak wave that sank the Big Fitz in John Mauldin's latest Outside the Box, with our Italian "rogue wave-soliton".
In fact we could go further into the analogy relating to the "three sisters" rogue waves that sank SS Edmund Fitzgerald - Big Fitz, given we are witnessing three sisters rogue waves in our European crisis, namely:
Wave number 1 - Financial crisis
Wave number 2 - Sovereign crisis
Wave number 3 - Currency crisis
In relation to our previous post, the Peregrine soliton, being an analytic solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), it is "an attractive hypothesis to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace" - source Wikipedia.

But I ramble once again, and given poor liquidity, and recent price action it is time for another credit overview. In the process we will review the unfolding scenarios we have been discussing in recent months, namely liquidity issues leading to a financial crisis, contagion to Emerging Markets (Eastern Europe in the front line), bond tenders and more. So, yet another long conversation.

The Credit Indices Itraxx overview - Source Bloomberg:
We still have high volatility, with Itraxx Credit Indices experiencing big price movements, in an environment where liquidity is definitely dwindling.
A market maker in fact commented on today's price action:
"One of the worst days of the year in terms of flow biz if it can be considered that anymore. A difficult environment to trade with clients mostly on the sidelines watching the Hollywood horror flick become a reality as SOV cash got decimated, particularly in the front end. Underperformers today the Italian/French/Iberian names which closely followed the Sovs. Even names like RBS & Lloyds SUB which are considered the "hairier" of the UK names failed to widen as much."
European Financials wider:
[Graph Name]
Italian Financials 5 year CDS were wider by around 70 bps on the day with Senior Financials CDS trading from 495 bps up to 760, depending on the Italian bank.
Spanish Financials 5 year Senior CDS were wider as well (BBVA +90 bps, Santander +80 bps).
French Senior Financial 5 year CDS also took a severe beating with Credit Agricole wider by 55 bps to around 570 bps, Societe Generale wider by 30 bps to around 370 on the 5 year Senior 5 year point and BNP Paribas wider by 55 bps to around 300 bps on 5 year Senior.

The issue of circularity for financial spreads and correlation with sovereign spreads is alive and well:
Daily Focus Graph

In relation to the bond picture, contagion has been spreading to core Europe with France drifting wider still - source Bloomberg:

And, if we only look at core Europe, it seems Austria is effectively now drifting in tandem with France towards 4% yield with core Europe now only made of Netherlands, Finland and Germany - source Bloomberg:
We previously discussed Austria's banking issues relating to Eastern Europe exposure, namely Hungary in our previous post "Long hope - Short faith" and why I was closely monitoring the situation.
On the 11th of October I indicated:
"I am expecting Austria's sovereign CDS to trade wider than France at some point, given the exposure of Austria's banking sector to Eastern Europe and in particular Hungary where a new law has been passed allowing foreign currency mortgages borrowers in Hungary to repay their loans at a fixed exchange rate with large discounts to current FX market rates, which will trigger losses to Austrian Banks."
In relation to the Hungarian situation we discussed a month ago:
"Under the new legislation borrowers can repay their mortgage in a single instalment at a HUF/CHF rate of 180 or a HUF/EUR rate of 250. Current FX rates are around 239 for HUF/CHF and HUF/EUR is around 297, a 25% and 16% discount according to CreditSights."
HUF/EUR rate was 297 at the time, and is now much higher (315), meaning losses for European banks and in particular the likes of Austrian Erste Bank exposed to these mortgages will be significantly higher - source Bloomberg:

In our conversation "Leda and the (Greek) Swan and why Europe matters more for Emerging Markets", we indicated that "European banks’ lending to Hungary amounted to more than 70 percent of that country’s GDP, according to estimates by Barclays Capital based on BIS data. Lending to Poland reached 40 percent of GDP, and that to Brazil and Mexico was equal to about 20 percent of their economies." Following up on our Austrian conversation, it is interesting to see it followed up by Eric Frey from the Financial Times - "Austria moves to defend top rating" as well as by Geoffrey T. Smith from the Wall Street Journal - "Austria Has a Déjà Vu Moment":
"Austrian banks’ foreign assets at the end of 2010 were 137% of domestic GDP, according to Raiffeisen Zentralbank.

Data published in the European Banking Authority’s stress tests showed a combined exposure of around €210 billion to central and Eastern Europe, although that excludes loans made to the region through Unicredit SpA’s local subsidiary, Bank Austria.

Those assets have generated stellar growth over the last 15 years for the banks, but a small domestic economy can hardly underwrite them if things turn sour.

By contrast, the Bank for International Settlements suggests that Austria’s exposure to the five most indebted countries of the euro zone is relatively modest, with even Italy accounting for no more than €18 billion.

As a result, the biggest threat to Austrian banks is still what it was in 2009—wholesale capital flight from emerging Europe."

In relation to the deleveraging risks for Emerging Markets coming from European banks we discussed on the 2nd of November, Morgan Stanley in a report published on the 13th of November entitled "What Are the Risks of €1.5-2.5tr Deleveraging?" had to say the following:
"Contagion to EM is a key risk, although our concerns centre on CEE/SEE rather than Asia. 12 of the 16 major European banks in CEE (~78% of these banking assets) either had a capital shortfall in the recent 9% test or are TARP recipients. We expect the greatest strain in SEE. In contrast, while we see growing risks to global trade finance – French banks looking to reduce dollar dependency represent 25% of outstandings – our assessment is that in a more orderly scenario this will be passed to local banks or globals (HSBC, STAN, C, JPM) although clear risks if disorderly."
The Morgan Stanley report was also quoted in relation to the heightened possibility of a Credit Crunch in Europe by Lisa Pollack in ft.com/Alphaville in "It’s a capital ratio of two halves" who has been following up on our post "Leda and the Greek Swan" (published by Pragmatic Capitalism courtesy of Cullen Roche) in relation to the impact of deleveraging.

The truth is that the liquidity picture is not improving, it is sliding still - source Bloomberg:
We have discussed at length upcoming term funding issues (in our post "Complacency"), and why liquidity issues always trigger financial crisis.

Morgan Stanley in their report commented:
"Bank funding roll is considerable – €1.7tr of debt due to refi for the major banks in the next three years. We think a step change in the pricing and availability of senior unsecured debt as well as dollar funding challenge many businesses. Whilst intense ECB support has helped, lack of a temporary bank debt guarantee plan is unfortunate, we feel.

Funding is no small issue. European banks lost $100bn of CP over the summer alone – making some major European banks more dependent on the ECB for funding. Given the dollar is the functional currency of global trade, this will impact European banks’ ability to be global lenders."
In relation to the issue of circularity, Morgan Stanley has come up with an interesting illustration - Source Morgan Stanley Research:

In fact financial stocks performance has been deeply correlated to Sovereign risk according to Morgan Stanley research:

We already know how difficult term funding issuance has been in recent months and is an ongoing problem moving towards 2012 - source Morgan Stanley Research:

Itraxx Financial Senior 5 year CDS index evolution versus Itraxx Financial Subordinate 5 year CDS index - source Bloomberg:
Moving back towards the widest levels reached in September.

Here is Morgan Stanley's take on the subject:
"• Term markets have stuttered throughout the summer, unable to regain the momentum of H1; there have been ~30 covered bond deals and a handful of senior unsecured since late August.
• However, our 2011 funding survey shows that European banks are now 100% funded on average, having frontloaded their issuance inH1.
• Notably, the Nordics and BNP have prefunded some of 2012.
• But given the sector has ~€700bn of rolling debt in 2012, we see headwinds if funding conditions persist, resulting in a pick-up in the velocity of delevering and further compression of NII (Net Issuance)."

In that context, it is of no surprise to see a rise in bond tenders (on that subject please refer to our post "Subordinated debt - Love me tender?") , in fact Spanish bank Santander just announced a bond tender on 9 callable LT2 bonds:

Santander Issuances, S.A. €1,500,000,000 - Exchange ratio 90.50 (%)
ISIN - XS0291652203 - Callable Subordinated Step-Up Floating Rate Instruments due 2017
Santander Issuances, S.A. €550,000,000 - Exchange ratio 90.00 (%)
ISIN - XS0261717416 - Callable Subordinated Step-Up Floating Rate Instruments due 2017
Santander Issuances, S.A. €1,500,000,000 - Exchange ratio 90.00 (%)
ISIN - XS0327533617 - Callable Subordinated Lower Tier 2 Step-Up
Fixed/Floating Rate Instruments due 2017
Santander Issuances, S.A. £300,000,000 - Exchange ratio 88.00 (%)
ISIN - XS0284633327 - Callable Subordinated Step-Up Fixed/Floating Rate
Instruments due 2018
Santander Issuances, S.A. €500,000,000 - Exchange ratio 88.00 (%)
ISIN - XS0255291626 - Callable Subordinated Step-Up Fixed/Floating Rate
Instruments due 2018
Santander Issuances, S.A. €500,000,000 - Exchange ratio 87.00 (%)
ISIN - XS0301810262- Callable Subordinated Step-Up Fixed/Floating Rate
Instruments due 2019
Santander Issuances, S.A. €449,250,000 - Exchange ratio 99.50 (%)
ISIN - XS0440402393- Callable Subordinated Lower Tier 2 Step-Up
Fixed/Floating Rate Instruments due 2019
Santander Issuances, S.A. £843,350,000 - Exchange ratio 94.00 (%)
ISIN - XS0440403797- Callable Subordinated Lower Tier 2 Step-Up
Fixed/Floating Rate Instruments due 2019
Santander Issuances, S.A. €500,000,000 - Exchange ratio 87.00 (%)
ISIN - XS0201169439- Callable Subordinated Lower Tier 2 Step-Up
Fixed/Floating Rate Instruments due 2019

In our new Santander proposed haircuts, bond holders have until the 23rd of November to decide if they want a new "hairstyle".

Not even our CPDO/EFSF has been successful in raising recently much needed funding to help out on the ongoing European debt crisis, in fact, 10 year French Government bonds are yielding now for the first time above June issued 10 year EFSF bond - source Bloomberg:
It looks like the EFSF is too late to be materially effective in preventing contagion to spread in Europe.

So, given what we know so far, with heightened volatility, liquidity dwindling and European solitons, as in indicated in our previous post, please "mind the gap" - source Bloomberg:
There is still a disconnect between the 10 year German Bund and the Eurostoxx, while it had been moving in lockstep until recently, it appears the divergence between both still does not look correct, and warrant caution.

On a final note I leave you with the European Zew Indew, relating to European investor and analyst expectation - source Bloomberg:
"The ZEW center in Mannheim Germany said today its index of investor and analyst expectations, which aims to predict developments six months in advance, declined to minus 55.2 from minus 48.3 in October. That’s the lowest since October 2008." - Source Bloomberg.

"If we take the generally accepted definition of bravery as a quality which knows no fear, I have never seen a brave man. All men are frightened. The more intelligent they are, the more they are frightened."
George S. Patton

Stay tuned!

Wednesday, 9 November 2011

Markets update - Credit - The Italian Peregrine soliton

"In mathematics and physics, a soliton is a self-reinforcing solitary wave (a wave packet or pulse) that maintains its shape while it travels at constant speed." - source Wikipedia

"A single, consensus definition of a soliton:

1. They are of permanent form;
2. They are localised within a region;
3. They can interact with other solitons, and emerge from the collision unchanged, except for a phase shift." - source Wikipedia

Another interesting day in the ongoing European crisis.

It is of no surprise with liquidity dwindling as we move towards year end to see a lot more ongoing volatility, definitely not helping. It seems Six Sigma standard deviation is not the norm anymore, it is higher still. So another long post, focusing on our Italian Peregrine soliton, liquidity issues affecting bid-offer prices and touching on fine-tuning risk weighting assets for banks to shore up Core Tier 1 capital.

Italy took centre stage today with some epic price movements:

Italian 2 years:  --- 6.37 yesterday ---- 7.13 today ---- +75 bps

Italian 5 years:  --- 6.87 yesterday ---- 7.62 today ---- +75 bps

Italian 10 years: --- 6.77 yesterday ---- 7.38 today ---- +61 bps

Time for a market overview.

The Bond Picture - Source Bloomberg:
Italy reaching "Terminal velocity"? The move today was epic to say the least.

Here is the intraday picture for 10 year Italian Government bond yield move- Source Bloomberg:

The CDS picture, Italy and Spain 5 year Sovereign CDS drifting apart - Source Bloomberg:
New record, 140 bps apart.

In the process, CDS wise, everything Italian widened - Source CMA:
[Graph Name]

Banks as well as Italy and Italian Companies - Source CMA:
Daily Focus Graph

Triggering in the process, flight to quality, Germany 10 year Government bond trending back to record lows - Source Bloomberg:

There is an interesting disconnect between the move in the 10 year German Bund and the Eurostoxx, while it had been moving in lockstep until recently, it appears the divergence between both does not look correct, so mind the gap - Source Bloomberg:
Volatility rising in the process as shown in the bottom level of the graph displaying 6 month implied volatility and V2X index.

France as well was not spared either with today's price action, given its exposure to Italy, with the 10 year Government bond spread level with Germany reaching another record in the process, coming close to 150 bps - Source Bloomberg.

OAT and EFSF Bonds widening versus German 10 year Government Bond yield - Source Bloomberg:
At this stage we know that EFSF will not be enough to deal with ongoing contagion to Italy.

The liquidity picture, not improving, new reserve period starting at the ECB hence the drop in the deposit levels at the ECB - Source Bloomberg:

In relation to liquidity dwindling as we move steadily towards year end, and dealers not particular eager to add risk towards year end, bid-offer spread are rising, but in relation to Italian debt, they have been soaring according to Bloomberg Chart of the Day relating to 2 year Italian Bonds bid-offer spreads:
By Matthew Brown - November 9 - Bloomberg:
"The gap between prices at which traders buy and sell Italian bonds has soared this week as market makers became less willing to deal in the nation’s debt, sapping liquidity from Europe’s largest bond market.
The CHART OF THE DAY shows the so-called bid-ask spread on Italian two year notes. The gap widened to 44 basis points today, the most since January, and up from 4 in March. Italian two-year yields climbed 98 basis points to a euro-era record 7.36 percent today, while 10-year yields climbed above 7 percent, the level that presaged Greece, Ireland and Portugal requesting international bailouts."

In recent post we have been discussing how banks will need to tackle revamped regulation needing them to beef up their core Tier 1 capital, as required by the European Banking Association.
We have already touched on the subject of DVA, bond tenders, debt to equity swap, upcoming deleveraging and of course reduction of appetite for risk with the reduction of the size of the trading book via attrition of Risk-Weighted-Assets.
As indicated by Bloomberg today by Liam Vaughan in his article "Financial Alchemy Foils Capital Rule as EU Banks Redefine Risk". It is worth mentioning the creativity of banks in dealing with capital rules imposed by regulators. When rules doesn't work your way, it is time to adapt:
"Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.
Banco Santander SA, Spain’s largest lender, and Banco Bilbao Vizcaya Argentaria SA, the second-biggest, say they can go halfway to adding 13.6 billion euros ($18.8 billion) of capital by changing how they calculate risk-weightings, the probability of default lenders assign to loans, mortgages and derivatives. The practice, known as “risk-weighted asset optimization,” allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders.
Regulators in Europe, seeking to stem the region’s sovereign-debt crisis, ordered banks last month to increase core capital to 9 percent of risk weighted assets by the end of June."

And from the same article, an interesting comment from Adrian Blundell-Wignall deputy director of the Organization for Economic Cooperation and Development’sfinancial and enterprise affairs division in Paris:
"By allowing sophisticated banks to do their own modeling, we are allowing the poacher to participate in being the game-keeper”.

Yes, every bank uses their own models for calculating their RWA (Risk-Weighted-Assets) which are submitted once a year to national regulators according to the article.

Also from the same article:
"Sheila Bair, who stepped down as chairman of the Federal Deposit Insurance Corp. in June, has called Europe’s adoption of risk-weighting “naive.” The Washington-based regulator guarantees most consumers’ deposits in U.S. banks. “It is in a bank manager’s interest to say his assets have low risk, because it enables the bank to maximize leverage and return on equity, which in turn can lead to bigger pay and bonuses,” Bair wrote in Fortune magazine on Nov. 2. “Indeed, even during the Great Recession, as delinquencies and defaults increased, most European banks were saying their assets were becoming safer.
Some regulators, including Bair, have pushed for a leverage ratio that would require lenders to hold a fixed amount of capital against total assets.
One reason there’s a difference between risk-weighted assets and total assets is that some securities, such as certain sovereign bonds, carry a zero risk-weighting, requiring banks to hold no capital.

‘Gaming the System’

“A basic leverage ratio would be rougher, but it takes away the risk of gaming the system,” said Stephany Griffith-Jones, an economist and lecturer in financial markets at Columbia University in New York. “We need to move away from outsourcing regulation of the banks to the banks.” European bank stocks have tumbled 31 percent this year, valuing firms at 62 percent of tangible book value."
And the article to conclude quoting Mark Harrison, a Barclays
analyst, who is based in London:
“Gaming RWAs isn’t helpful, particularly if the objective is to convince the market to invest in banks again,” Harrison said. “The risk is that it’s counterproductive, because there
is even less faith in what the banks are telling you.”
Raising capital for Banks is therefore going to be an interesting exercise indeed in the coming months.

"Running a casino is like robbing a bank with no cops around." Ace Rothstein (Robert de Niro) in the movie Casino by Martin Scorsese

"Running an investment bank is like robbing a casino with no gaming regulators around."
Martin, Macronomics.

Stay Tuned!

Sunday, 6 November 2011

Markets update - Credit - Complacency

"Don't let your special character and values, the secret that you know and no one else does, the truth - don't let that get swallowed up by the great chewing complacency."

At this juncture, following our various credit and markets conversations, it is important to revisit some of the points we have discussed in relation to liquidity, funding pressures and deleveraging, and in the process, revisiting some of our calls.

But, before we go through the details (and the truth is in the detail...), it is time for a quick market overview relating to Friday's price action.

The Credit Indices Itraxx overview - Source Bloomberg:
What we have is extreme volatility, with Itraxx Credit Indices experiencing big price movements, in an environment where liquidity is dwindling, as we move towards year end, it will make matters not better but worse. Nearly 90 bps intraday move on Friday for Itraxx Crossover (High Yield indicator). To give you an idea, on a 10 million Euros notional Itraxx Crossover CDS, contract, 1 basis point movement equates to around 3500 Euros (DV01) move in your marked to market Profit and Loss.

And in relation to the European High Yield market, it briefly re-opened, we had Ba3 rated Faurecia coming to the market with a Senior Unsecured 350 million Euros 2016 bond offering at 9.375% yield. Faurecia is one of the largest international automotive parts manufacturers in the world. French car manufacturer PSA Peugeot Citroën is Faurecia's controlling shareholder, holding around 57.4% stake. Faurecia is in a cyclical business. In 2008 it breached its loan covenants.

While Natalie Harrison from Reuters, in the deal review gives us the reason for the financing in her article "DEAL REVIEW: Faurecia debut survives high-yield storm":
"The bond, executed in conjunction with a new syndicated loan facility, will refinance a EUR250m loan that parent Peugeot was forced to put in place three years ago when four banks backed out of lending to the company.
The bond is also part of the company's well-publicised plans to diversify its funding sources away from banks and follows its fund-raising in the schuldshein market the previous week."

There are two important points above, remember the truth is in the detail, the proceeds will be used to repay the facility set up by parent company due to previous funding issues encountered in 2008, lack of funding because banks are deleveraging, meaning credit contraction, which we know by now will have economic consequences. Morgan Stanley published a very interesting paper on the 4th of November - Credit Continuum - Understanding Credit in a Low Yield World:
"HY vs. IG: Owing to callability, economic sensitivity, duration and default risk, we find that high yield tends to have weaker performance than investment grade in falling rate environments."
And in relation to the ECB rate cut, I am afraid, it is coming late and it is "Much ado about nothing" as a senior credit market maker commented:
"The ECB rate cut was another surprise for the market and shows that the mild recession has already reached Europe as I expected."
And added:
"The rate cut will help sentiment but not really the refinancing need for Governments."
 In terms of financing needs for 2012, we discussed this subject with Cullen Roche in his post - "THE IMPOSSIBLE REFINANCING BURDEN...."

The Government Bond picture:
Italian bond yields creeping higher still...

Flight to quality mode is switched on again - "Risk-off", German 5 year sovereign CDS versus 10 year German Government Bonds yield:

But, in a low yield environment, defaults tend to spike.

Morgan Stanley in their note relating to "Understanding Credit in a Low Yield World added:
"Low Yields Tend to Coincide with Higher Spreads and Default Rates: While low yields are often associated with slow growth, thereby justifying wider credit spreads, other factors can keep spreads wide, including the trouble companies have in inflating away their nominal debt (higher default risk). History tells us that if growth eventually picks up while yields stay low (1930s-1950s), spreads can indeed normalize."
Deflation is still the name of the game and it should be your concern credit wise (in relation to upcoming defaults), not inflation as per Morgan Stanley's note:
"While one could argue that default rates could be high during times of higher yields owing to higher debt service cost, the opposite is actually true. High inflationary environments allow corporations to inflate away their nominal debt as their assets (and revenues) grow with inflation, leading to lower default rates. Low inflation environments, like the one we’ve had for the past 25 years, tend to be ones where defaults can spike."

The liquidity picture is Europe is not improving - Source Bloomberg:
We all know by now why liquidity matters...

So, no time for complacency, as my good credit friend put it from our conversations in a couple of sensible points:
"As we move now toward the end of the year and the market still seems to have some momentum to go higher (both in equity and in credit prices), I would like to focus on various news and information that will drive the market in the future.

1-Bank of America Corp. may bolster its balance sheet by exchanging preferred securities for a total of $6 billion of common shares and debt. The proposed transactions may lower interest and dividend costs and improve capital levels, the Charlotte, North Carolina-based lender said in a regulatory filing. The firm may seek to issue as much as 400 million common shares and $3 billion of senior notes in privately negotiated deals...Will other banks follow suit? We have already seen European banks trying to raise capital ahead of the European Summit decision: Tier 1 tender offer at some steep discount (BPCE, Banco Espirito Santo) and Subordinated Debt tender/exchange for equities (Banco Espirito Santo) at a big cost for both bonds and shares holders…I think we will see more banks taking the same path to raise capital in the next 9 months.

2-The EFSF leverage details are still unknown and the SPV supposed to attract investors...has not attracted real money so far. There have been a lot of words and hope, but nothing real. So a lot of assumptions about the efficiency of “The European Backstop” may well appear to be wrong.

3-Greece will not be able to pay its debt with the actual “voluntary 50% haircut” accepted by private investors. I crushed the numbers many times; the Greek total debt reduction will not be bigger than 35% of the country total liabilities, which is far from being enough for the economy to recover. I expect more pain for debt holders in the future, unless Greeks decide on what they can afford to repay.

4-The European economy is already in a mild recession. Even the new ECB chairman acknowledges it. But banks balance sheet deleveraging and austerity budgets throughout Europe will weigh more on the economy, which will have far reaching consequences worldwide. I think the outcome is totally under estimated by market players. As an example, according to the BIS, European banks lend today roughly $ 3.5 trillion to the emerging countries, while the number for the US banks is only roughly $ 975 billion, and for Japanese banks about $ 750 billion.

5-Starting in January 2012, the refinancing needs for States, banks and corporate will be “enormous”. It will occur at a time of economic weakness, with a looming credit crunch. Do not be too complacent as there will necessary be casualties."
We discussed bond tenders from point number 1 in our post "Subordinated debt - Love me tender?":
"We expected others to follow suit and given the difficulty for the weaker players in the peripheral space to access capital at a reasonable rate, as well as needing to boost their core Tier 1 capital base, it was of no surprise to see Portuguese bank Banco Espirito Santo following French bank BPCE in tendering some of its subordinated debt on the 18th of October, but this time around, we have a debt to equity swap"

My good credit friend commented at the time:
"Banco Espirito Santo total market cap is approximately euro 1,743 million…which means 83.5% dilution for the current shareholders!"
And I added:
"So, in our debt to equity swap, courtesy of the subordinated bond tender, not only the subordinated bond holder is taking a hit, but our shareholder as well. Love me tender?"

Here is a recap on the levels for Banco Espirito Santo Tier1 Subordinated bonds as of the 3rd of November:
EXCHANGE LVL @ 1.80 (equity price at the time of exchange...)
BESPL 5.58% 07/14 41/45 (cash price) - 61 (47.5 adj)
BESPL 4.5% 03/15 46/49 (cash price) - 66 (51.3 adj)
BESPL 6.625% 05/12 52/56 (cash price)- 74 (57.6 adj)
Adj. exchange px calculated using current stock price (1.40)

The recent European Banking Association reaction relating to beefing up Core Tier 1 capital to 9% before June 2012 is akin to shooting oneself in the foot. How can you raise private capital in these challenging market conditions and refinance at the same time?

On that very subject, JP Morgan published its Banking Sector Outlook for 2012 on the 4th of November entitled - The Great Bank Deleveraging:
"In our opinion European banks increasingly face the challenge of being stuck between a rock (increased regulatory requirements) and a hard place (pressure to grow lending whilst facing increasing funding pressures). Banks will need to deal with increased funding and solvency pressures, in addition to regulatory constraints on liquidity management, which ultimately should incentivize banks to reduce balance sheets. We think that this strategy will mostly be undertaken by banks rolling over a lower proportion of non-loan assets and loan commitments at maturity, rather than the aggressive pursuit of asset sales."

And JP Morgan to estimate the impact:
"Given these constraints, we have modelled a deleveraging strategy for a peer group of 28 of the largest European banks for which we estimate a net reduction of €834bn in assets over a 12 month period. We highlight that this reduction in balance sheet size is mostly driven by the attrition of loan and non-loan assets as these mature, with limited scope for asset sales given the potentially negative impacts on solvency. In our opinion there is greater scope for deleveraging of non-loan assets such as securities inventories as these reach maturity given that these may not be eligible for the purposes of LCR (Liquidity Coverage Ratio). If we scale up our estimate of balance sheet reduction to the broader European banking sector we derive a total deleveraging outcome of €1,993bn which would represent 4.7% of total sector assets and is in line with the recent guidance from the IIF (Institute of International Finance). It will be difficult to assume that such deleveraging will not have an impact on the broader economic environment."
And in relation to term funding, JP Morgan estimates:
"We expect that term refinancing pressures are likely to persist for the European banking sector in 2012, particularly given the more limited scope for Yankee issuance which was valuable support for the sector in H1’11. In our opinion the implementation of a guarantee scheme will be crucial in achieving some type of market normalization and we think is a preferable alternative to the extension of tenors on ECB liquidity facilities. We think that a guarantee scheme will necessarily have to operate at a supra sovereign level, with the pricing of such facilities being more problematic than they were in 2008/09 given the difficulty in establishing pre-crisis spread levels for the participating banks. While there has been a lot of focus on the reduced access of European banks to US money market funding, we expect that this will be replaced by increased recourse to ECB funding."

JP Morgan also agrees with our previous discussions relating to debt tenders and debt to equity swaps trend:
"Our base case is that the implementation of a statutory bail-in regime will result in the authorities having the discretion to impose losses on the more subordinated parts of the capital structure (Tier I and Tier II) before exposing taxpayers to potential losses. In our opinion there is a lot less resistance to forcing losses on legacy subordinated debt instruments, as we have seen amongst the Irish banking sector where specific legislation provided the flexibility to force such losses, an outcome which in future may be achieved under a standardized resolution regime.
We also highlight increased risks with regard to issuer behavior on the exercising of calls on legacy Tier I and Tier II capital instruments."*
*This is exactly what we previously discussed in our post "Crash Test for Dummies" on the 18th of September:
"But, it is clear that not all banks have the same liquidity/funding costs, particularly today. So the game is going, once again to be as follows, remember: "The recent significant increase in credit spreads for many financials have been driven by the markets concerned about the ability of the weaker players to access credit at reasonable rates." (Macro and Markets update - It's the liquidity stupid...and why it matters again... ), banks with access to cheaper senior term funding than the cost of their outstanding LT2, for them, an early call could make sense, compared to the cost of issuing senior debt. For the others, I am not so sure..."

I concluded at the time:
"So, dear credit friends, I am afraid to say that, skipping calls, are going to happen, and will trigger losses because end of the day, why would you call a bond, if it costs you more to issue a new one?

This time is different? Nope. It is still deleveraging."
As Aesop put it: "the truth - don't let that get swallowed up by the great chewing complacency."

In relation to the EBA's estimate of 106 billion euro of capital shortfall for bank, it is complacent, to say the least...
Here is what JP Morgan had to say relating to the above in their report:
"We therefore subject the 70 institutions defined in the last stress test to the incremental stress from the July exercise as well as the valuation adjustments of the October test to a core Tier I ratio of 9%. While we acknowledge that time may have been a factor for the last EBA stress tests, we think that it would have been relatively straightforward to make the necessary adjustments to derive a more complete picture for the sector’s solvency requirements. Under these scenarios we highlight that the capital shortfall for the sector for the 70 banks goes from a risible €0.9bn in July to the €106bn in October, with our combination of these stress scenarios highlighting a capital shortfall of €280bn. While time may have been a factor in the EBA producing a more limited stress test, we also note the very obvious inconvenience of producing a capital shortfall which may have been significantly beyond the available resources."
No stress, no test; no test, no stress...

As a reminder from our conversation "Long - Hope Short Faith":

"Something has gotta give" - subordinated bondholders or shareholders, or both:

And DVA will bite back shortly as well bank earnings, remember it works both ways, on spread widening, as well as on spread tightening...I call it the boomerang effect.

On a final note, here is what UBS had to say relating to Sovereign CDS in relation to naked ban and CDS not triggering on the 4th of November "Unintended consequences":
"Although the sovereign CDS market is small in terms of net exposure, the consequences could be severe if belief in the instrument’s ability to pay out wavers or there is an outright ban on sovereign CDS. Investment bank counterparty risk management depends on sovereign CDS to hedge sovereign exposure, as does market making of government bonds in the secondary market. A loss of faith in sovereign CDS as a hedge would force market makers to cut their inventory, which would lead to a rise in sovereign yields and funding costs. Sovereigns could be shut out of the OTC market as banks would be unable to hedge their counterparty exposure."
"My dear brothers, never forget, when you hear the progress of enlightenment vaunted, that the devil's best trick is to persuade you that he doesn't exist!"

Charles Baudelaire, French poet, "Le Joueur généreux," pub. February 7, 1864

"The greatest trick the devil ever pulled was to convince the world he didn't exist"
Roger "Verbal" Kint- The Usual Suspects

Stay tuned!

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